FX Rates Unification Will Halt Arbitrage, Smuggling - Report
Godwin Emefiele, CBN Governor

FX Rates Unification Will Halt Arbitrage, Smuggling – Report

Foreign exchange (FX) rates unification will halt arbitrage, smuggling says International Institute of Finance (IIF) in a new report, adding that unified market-clearing exchange rate is critical for restoring macro stability, strengthening investment and growth.

Nigeria reintroduced foreign exchange rationing following the sharp fall in oil prices in 2015. The persistent opaque rules of foreign exchange allocation have created uncertainty for the private sector, encouraged smuggling, and enabled corruption, IIF said.

IIF noted that Nigeria, Algeria, Iran and Turkmenistan top the lists of countries that have tolerated high premium on foreign exchange for a long period, a situation that creates arbitrage opportunities in the market.

However, despite effort to manage FX rates, the Institute said the still-large spread between the official and parallel market rates has created arbitrage opportunities for a small segment of the population.

These include large corporations and the elite, who buy U.S. dollars at the official rate and sell at the parallel rate amidst widening spread despite the CBN control efforts.

According to the Institute, a transparent, market-based foreign exchange rate policy is needed in Nigerian to instill confidence and diversify the economy.

It said a unified and flexible exchange rate system would also help to attract more non-resident capital flows, particularly FDI, which have dropped in recent years, noting that unification attempt should be accompanied by a significant increase in the policy rate to prevent excessive overshooting and contain inflationary pressures.

The report explained that currently, 22 countries, representing 12% of the world total, are classified as having more than one exchange rate.

IIF said in the current difficult global environment, confronted by both global and country-specific challenges, central banks in some countries with multiple exchange rates have held back from tightening monetary policy and from undertaking the reforms to their exchange rate systems necessary to achieve successful unification.

Drawing on the findings, IIF said it attempts to respond to questions like what policies are required to sustain unification, what explains the differences in the size of the parallel premium – the percentage by which the parallel exchange rate exceeds the official rate- across countries and over time.

It said an official exchange rate significantly stronger than a market-clearing rate will discourage foreign direct investment (FDI), reduce the interbank FX market, encourage rent-seeking, and impede business development.

“A unified market-clearing exchange rate (that balances demand and supply of FX) is critical for restoring macro stability and strengthening investment and growth.

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“It can also bolster competitiveness and transparency, eliminate the distortions associated with multiple currency practices, boost central bank independence, and minimize rent-seeking activities that increase risks of corruption”, it added.

IIF posits that flexible exchange rate regimes also support fiscal consolidation by boosting import-related revenues and budget oil receipts in local currency as seen in Angola, Nigeria, Turkmenistan, and Uzbekistan, noting that large premia encourage smuggling or illegal trade.

In Lebanon, for example, IIF said with the spread between the official and parallel rate around 700%, the central bank has subsidized the imports of basic products like fuel by using the highly appreciated official exchange rate.

However, a significant portion of the imported fuel is smuggled to Syria as high parallel premiums also contribute to higher domestic prices of goods that enter the country through parallel channels.

Successful unification hinges on the implementation of comprehensive reforms, including adequate fiscal and monetary policies as well as structural reforms that expand the role of the market in determining resource allocation.

The Institute said in the report that unified exchange rate system must be consistent with underlying credit and fiscal policies.

With respect to the speed of unification, it explained that experience from several countries shows that it may occur quickly, particularly when the dual exchange system no longer protects international reserves or domestic demand for FX remains unmet.

“This was the case in Egypt (unified in November 2016) and Sudan (unified in February 2021)”, it said.

There are also cases of successful gradual unification or significant narrowing of the spreads between the official and parallel rates, especially in Sub-Saharan African economies such as Ghana (January 2014 to June 2015), Angola (2017 to present), and Zimbabwe (June 2020 to present).

In these countries, IIF stated that the unification efforts included price deregulation, trade liberalization, and tighter monetary and fiscal policies, adding that expansionary monetary policy, widening fiscal deficits, or an appreciation of the real official exchange rate raise the parallel premium.

In countries that monetize fiscal deficits or fail to restrain monetary growth, the parallel rate depreciates further, and consumers’ price index inflation continues to rise (Argentina, Lebanon, and Sudan in 2020).

IIF said, “There is also a strong correlation between illegal trade and the parallel premium. Other factors that also contribute to wider spreads include sanctions (Iran and Syria) and political instability or paralysis (Lebanon).

“Official exchange rate devaluation usually reduces the spread significantly when accompanied with appropriate macroeconomic policies and improvement in non-resident capital inflows, preferably with an IMF program”.

Evidence from countries that adjusted their official exchange rate close to the parallel rate suggest the Adjustment of the official rate to a market-clearing level does not necessarily lead to further depreciation.

Also, a parallel market can persist for decades as in case of Algeria and Turkmenistan, saying that implementation of tight monetary and fiscal policies and structural reforms will help to stabilize the unified exchange rate beyond the near term.

As inflation before the exchange rate adjustment reflects largely the movement in the parallel exchange rate, pass-through from the adjustment of the official rate close to the parallel rate tends to be modest.

It noted that attempts by the authorities to enforce foreign exchange controls have proven to be ineffective, in the case of Lebanon, and Iran.

Experts explained that a devaluation of the official exchange rate by itself will not narrow the spread between the official and parallel rates beyond the near term in the absence of strong fiscal adjustment, tighter monetary policy, and liberalization of the exchange market system.

Indeed, depending on the factors that spurred the emergence of a parallel market in the first place, depreciation may continue after the exchange rates are unified, potentially overshooting the equilibrium rate at first.

However, the exchange rate may subsequently appreciate as long as the authorities address the underlying causes of the parallel market.

FX Rates Unification Will Halt Arbitrage, Smuggling – Report